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Only last March, speculators were piling into shares in newly-listed hedge fund company RAB Capital. At their peak they hit 63p, making the firmâs co-founders, Philip Richards and Michael Alen-Buckley, worth Â£95m each on paper.

Mike Foster

Mere months later, RAB Capital’s shares have subsided to 36p. Despite a rise in half-year profits from £426,000 to £2.1m, RAB’s remark that second-quarter profits had been disappointing spooked investors.

The fact that the company had decided to invest in coal fields, gold mines and fuel cell companies also queered the pitch.

Investors reason that if a hedge fund specialist felt the need to diversify out of hedge funds, so should they. For good measure, Thames River, another hedge fund company, has just decided to back a real estate operation.

Hedge fund values have failed to recover the ground they lost in April and May. Shares in Man Group are close to a nine-month low as funds within its hedge fund network, including AHL, post disappointing performances.

The Hedge Fund Research global index has just posted a fall for July, meaning that this year has produced an unprecedented decline for four months in a row. Net losses for the year to date are 1.4%.

This, of course, is just what can be expected at a time when a lack of volatility in capital markets has reduced the number of available trading opportunities.

The one trend that hedge funds hate is a flat one. Unfortunately for them, it happens to be the trend that the Federal Reserve likes to see ahead of a US Presidential election.

Fund manager Jeremy Grantham, chairman of GMO, has carried out research into presidential cycles, and discovered that volatility in the last year of a presidency is invariably low.

The big question is how hedge funds will perform over the next year, rather than the next month or two. It will be a year that matters for everyone.

Opinion is balanced delicately between bulls and bears. The bulls point out corporate profit margins have rarely been higher; the bears say they will collapse in due course.

The market has never before been in a situation where hedge funds, leveraged by a factor of two, have held such sway. Long positions equivalent to, say, $2 trillion and short positions totalling $1 trillion are small in relation to the market. But the influence of hedge funds is heightened by the fact that they trade frenetically and love to follow trends.

Even the highly liquid currency market is regularly affected by hedge fund traders, say analysts.
Brokers in Mumbai have attributed the 22% fall in the Indian stock market to leveraged hedge funds closing down long positions, or possibly taking out shorts, following the election victory of Sonia Gandhi. It could be the harbinger of market moves to come.

Grantham, an infamous bear on the US market, makes the point that hedge funds have one thing in common: their total positions are net long illiquidity.

In other words, they tend to take long positions in situations which are ignored by mainstream investors because they are so thinly traded. They seek to balance these positions with shorts in stocks that are more liquid and easier to borrow.

The difficult trading conditions that are likely to coincide with rising interest rates and a presidential election year could easily produce a flight of capital from risky situations and a severe market correction.

Such events would not necessarily produce a crisis along the lines of the Long-Term Capital Management hedge fund blow-up in 1998. But they could prove uncomfortable for the new breed of hedge fund managers, who have enjoyed favourable trading conditions for years during which trends have been easy to spot and follow.

It could be even worse for the unprecedented number of managers that have just launched new hedge funds to take advantage of client demand.

According to Eurohedge, start-ups in Europe raised $9.4bn in the first half of this year, against $8.2bn during the same period for last year, when trading conditions were far easier.
Some hedge funds will be able to more than justify their fees by trading their way through the difficult conditions that could be approaching. But others will be driven out of business. Mainstream investors will be whipsawed by resulting volatility and could even feel obliged seek safety in government bonds.

No wonder the Securities and Exchange Commission is pushing for the registration of hedge funds. Disaster may not be inevitable but no regulator wants to risk being accused of inaction when the stakes are rising.

Equity needed

Employers are increasingly realising that they need to offer managers equity in their operations to guarantee their loyalty. In putting together its merger with Isis, F&C Management was quick to agree to offer such incentives.

In contrast, South African-owned Investec Asset Management recently lost the services of five UK equity managers, led by Nick Mottram, as its long-term incentive plans were not generous enough.

By all accounts before they left, Hendrik du Toit, Investec’s chief executive, pondered securing a majority bid for his London operation from Axa Investment Managers. Such a deal would have freed equity for du Toit’s managers as well as providing Axa with a robust equity process to balance Axa Rosenberg.

In the event, as is often the case these days, a price could not be agreed and du Toit is pressing ahead with rebuilding his operation. Mottram & Co’s new employer will soon emerge and it would be extraordinary if its managers did not end up with fistfuls of share options.